Papers

ABSTRACT (Click Here for Paper) Regulations that require asset issuers to disclose payoff-relevant information to potential buyers sound like obvious measures to increase investor welfare. But in many cases, such regulations harm investors. In an equilibrium model, asset returns compensate investors for risk. By making payoffs less uncertain, disclosure reduces risk and therefore reduces return. As high-risk, high-return investments disappear, investor welfare falls. Of course, information is still valuable to each individual investor. But acquiring information is like a prisoners' dilemma. Each investor is better off with the information, but collectively investors are better off if they remain uninformed. The two cases in which providing information improves investors' welfare are 1) where there would otherwise be severe asymmetric information, and 2) where the information induces firms to take on riskier investments. Using a model of information markets, the paper explores when such outcomes are likely to arise. When financial markets with information allocate the real capital stock more efficiently, disclosure improves efficiency, but more efficient firms do not offer investors higher returns. Investors only benefit when disclosure induces firms to take on riskier investments. Since the efficiency gains are fully captured by asset issuers, who can choose to disclose without disclosure being mandatory, the efficiency argument is not a logical rationale for regulation.

ABSTRACT (Click Here for Paper) The London Interbank Offered Rate (Libor) and the Euro Interbank Offered Rate (Euribor) are two key market benchmark interest rates used in a plethora of financial contracts with notional amounts running into the hundreds of trillions of dollars. The integrity of the rate-setting process for these benchmarks has been under intense scrutiny ever since the first reports of attempts to manipulate these rates surfaced in 2007. In this paper, we analyze Libor and Euribor rate submissions by the individual panel banks and shed light on the underlying manipulation incentives by quantifying their potential effects on the final rate set (the “fixing”). Furthermore, we explicitly take into account the possibility of collusion between several market participants. Our setup allows us to quantify such effects for the actual rate-setting process that is in place at present, and compare it to several alternative rate-setting procedures. We find that such alternative rate fixings, and larger sample sizes, could significantly reduce the effect of manipulation. Furthermore, we discuss the role of the particular questions asked of the panel banks, which are different for Libor and Euribor, and examine the need for a transaction database to validate individual submissions.

ABSTRACT (Click Here for Paper) We analyze asset-backed commercial paper conduits, which experienced a shadow-banking “run” and played a central role in the early phase of the financial crisis of 2007-09. We document that commercial banks set up conduits to securitize assets worth $1.3 trillion while insuring the newly securitized assets using explicit guarantees. We show that regulatory arbitrage was the main motive behind setting up conduits: the guarantees were structured so as to reduce regulatory capital requirements, more so by banks with less capital, and while still providing recourse to bank balance sheets for outside investors. Consistent with such recourse, we find that conduits provided little risk transfer during the “run”: losses from conduits remained with banks rather than outside investors and banks with more exposure to conduits had lower stock returns.

ABSTRACT (Click Here for Paper)Derivatives exposures across large financial institutions often contribute to - if not necessarily create - systemic risk. During a crisis, lack of adequate understanding of such exposures often compromises regulatory ability to unwind an institution, inducing large-scale backstops and counterparty bailouts. It is often argued - in spite of the massive assistance that was provided in this crisis to deal with derivatives exposures - that derivative contracts are well collateralized so that counterparty risk is not a significant issue (on derivatives exposures). While this may have been true in some cases, evidence suggests otherwise in many important cases that contributed to the crisis.2 Equally importantly, documenting such evidence beyond reasonable doubt is currently infeasible due to the poor quality of derivatives disclosures by financial institutions to regulators and to the public at large. Furthermore, a lack of standardization of existing disclosures aggravates the problem of obtaining any consistent inference across institutions.

ABSTRACT (Click Here for Paper) One “narrative” of the financial crisis of 2007-2009 is that poor corporate governance at financial institutions was a major cause of the crisis. An immediate implication of this narrative is that better corporate governance a better alignment of the interests of senior management with the interests of their shareholders would have prevented (or at least ameliorated) the crisis. This chapter argues that this corporate governance narrative is largely misguided and reflects an inadequate understanding of modern finance and financial theory. Because of the protections of limited liability, it is in the interests of diversified shareholders of a corporation (including financial institutions) to encourage senior managers to undertake greater risks than is in the interests of the corporation's creditors (or of regulators who may represent depositor creditors or the interests of society more generally). Consequently, public policy should look to improved prudential regulation, rather than improved corporate governance, for restraining the excessively risky activities of systemically important financial institutions.

ABSTRACT (Click Here for Paper) In this study, we analyze why commercial banks failed during the recent financial crisis. We find that traditional proxies for the CAMELS components, as well as measures of commercial real estate investments, do an excellent job in explaining the failures of banks that were closed during 2009, just as they did in the previous banking crisis of 1985 - 1992. Surprisingly, we do not find that residential mortgage-backed securities played a significant role in determining which banks failed and which banks survived. Our results offer support for the CAMELS approach to judging the safety and soundness of commercial banks, but calls into serious question the current system of regulatory risk weights and concentration limits on commercial real estate loans.

ABSTRACT (Click here for Paper) In response to the 2008 runs on deposit-like assets, namely repo and money market funds, the Fed created new liquidity facilities for nonbanking institutions and the Treasury guaranteed certain money market fund balances. These extraordinary actions, while justified by officials as necessary to preserve the financial system, did rescue nonbanks by exposing the public to unprecedented risks. Since 2008, despite legislation and regulation, deposit-like assets are still vulnerable to runs. The fallback policy to contain such runs is still ad hoc lending by the Fed. Bailouts, though officially outlawed, may very well be justified and used again. And, finally, because the implicit safety net of government action is still in place, moral hazard remains a feature of the financial landscape. This paper proposes that the Fed auction Federal Liquidity Options (FLOs) as the exclusive means of providing liquidity to nonbanks in a crisis. Having issued FLOs that encompass a sufficient quantity and breadth of collateral, authorities will be able to claim, with credibility, that no additional emergency lending programs or bailouts will be required to safeguard the viability of solvent nonbanks. In the resulting policy regime, the Fed does not rescue individual firms or industries but fulfills its contractual obligations under options previously sold at market-determined prices. Furthermore, with the cost of contingent liquidity internalized by the purchasers of FLOs, and with other extraordinary provisions of liquidity credibly renounced, moral hazard will drop significantly.

ABSTRACT (Click Here for Paper) We study the interbank lending and asset sales markets in which banks with surplus liquidity have market power, frictions arise in lending due to moral hazard, and assets are bank specific. Illiquid banks have weak outside options that allow surplus banks to ration lending, resulting in inefficient asset sales. A central bank can ameliorate this inefficiency by standing ready to fund illiquid banks, provided it is better informed than outside markets, or prepared to extend loss-making loans. This rationale for central banking and support in episodes that precede the modern central-banking era and informs debates on the supervisory and lender of last resort roles of central banks.

When liquidity chasing banks is high, loan officers (or risk-takers) inside banks expect future losses to be readily rolled over. This insurance effect induces them to relax lending standards. The resulting access to cheap credit can fuel asset price bubbles in the economy. To curb such risk-taking incentives at banks and the resulting asset bubbles, Central Banks should lean against bank liquidity. In particular, Central Banks should adopt a contractionary monetary policy in times of excessive bank liquidity.

We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, to induce effort, loan officers are compensated based on the volume of loans. Volume based compensation also induces greater risk-taking; however, due to lack of commitment, loan officers are penalized ex post only if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This ‘flight to quality' leaves banks flush with liquidity, lowering the sensitivity of bankers' payoffs to downside risks and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown.

ABSTRACT (Click Here for Paper) The Financial Economist Roundtable (FER) is a group of senior financial economists who have made significant contributions to the finance literature and seek to apply their knowledge to current policy debates. The Roundtable focuses on microeconomic issues in investments, corporate finance, and financial institutions and markets, both in the U.S. and internationally. Its major objective is to create a forum for intellectual interaction that promotes in-depth analyses of current policy issues in order to raise the level of public and private policy debate and improve the quality of policy decisions. FER was founded in 1993 and meets annually. Members attending a FER meeting discuss specific policy issues on which statements may be adopted. When a statement is issued, it reflects a consensus among at least two-thirds of the attending members and is signed by all the members supporting it. The statements are intended to increase the awareness and understanding of public policy makers, the financial economics profession, the communications media, and the general public. FER statements are distributed to relevant policy makers and the media.

ABSTRACTDiscussions of systemic risk after the financial crisis of 2007-09 have focused heavily on so-called “systemically important financial institutions” (SIFIs) a cohort of financial firms that is almost exclusively (but not necessarily) comprised of large, complex and heavily interconnected financial conglomerates. This paper considers the economic and strategic drivers of SIFIs - if such institutions are a key source of systemic risk, it is important to understand how and why they get that way. The paper then sets forth a public-interest perspective on the financial architecture by setting out key benchmarks - static and dynamic efficiency, stability and robustness, and competitiveness - and the tradeoffs that exist between them, and examines how SIFIs can support or detract from these benchmarks. If SIFIs are to be subject to much sharper prudential regulation, its impact must be calibrated against systemic performance benchmarks. Finally, the paper focuses on some of the major regulatory initiatives following the 2007-09 financial crisis, and in particular the US Dodd-Frank legislation of 2010, in terms of their possible impact on business models of SIFIs. The paper concludes that improving the financial architecture in a disciplined, consistent, internationally coordinated and sustained manner with a firm eye to the public interest should ultimately be centered on market discipline. By being forced to pay a significant price for the negative externalities SIFIs generate - in the form of systemic risk - managers and boards will have to draw their own conclusions regarding optimum institutional strategy and structure in the context of the microeconomics and industrial organization of global financial intermediation. If this fails, constraints on their size, complexity and interconnectedness will be a major part of the policy reaction to the next financial crisis.

ABSTRACT (Click Here for Paper)
One of the several regulatory failures behind the global financial crisis that started in 2007 has been the regulatory focus on individual, rather than systemic, risk of financial institutions. Focusing on systemically important assets and liabilities (SIALs) rather than individual financial institutions, we propose a set of resolution mechanisms, which is not only capable of inducing market discipline and mitigating moral hazard, but also capable of addressing the associated systemic risk, for instance, due to the risk of fire sales of collateral assets. Furthermore, because of our focus on SIALs, our proposed resolution mechanisms would be easier to implement at the global level compared to mechanisms that operate at the level of individual institutional forms. We, then, outline how our approach can be specialized to the repo market and propose a repo resolution authority for reforming this market.

ABSTRACT (Click Here for Paper) We examine the risk-taking behavior of money market funds during the financial crisis of 2007-10. We show that as a result of the crisis: (1) money market funds experienced an unprecedented expansion in their risk-taking opportunities; (2) funds had strong incentives to take on risk because fund inflows were highly responsive to fund returns; (3) funds sponsored by financial intermediaries that also ordered non-money market mutual funds and other financial services took on less risk, consistent with their sponsors internalizing concerns over negative spillovers to the rest of their business in case of a run; (4) funds sponsored by financial intermediaries with limited financial resources took on less risk, consistent with their sponsors having limited ability to stop potential runs. These results suggest that money market funds' risk-taking decisions trade of the benefits of fund inflows with the risk of causing negative spillovers to other parts of fund sponsors' business.

ABSTRACT (Click Here for Paper) We study the liquidity demand of large settlement banks in the UK and its effect on the money markets before and during the sub-prime crisis of 2007-2008. We find that the liquidity demand of large settlement banks experienced a 30% increase in the period immediately following August 9, 2007, the day when money markets froze, igniting the crisis. Following this shift, liquidity demand had a precautionary nature in that it rose on days of high payment activity and for banks with greater credit risk. This caused overnight interbank rates to rise, an effect virtually absent in the pre-crisis period.

ABSTRACT (Click Here for Paper) This paper studies how the implementation of Regulation of Fair Disclosure (Reg FD) affects the credit market. We argue that, although disclosing private information to lenders is exempt from Reg FD, this regulation imposes an additional disclosure risk on borrowers. We expect that borrowers will reduce information disclosure and increasingly rely on relationship lenders who have produced proprietary information about borrowers from their prior interactions. Our empirical results show that switching to new (non-relationship) lenders become more expensive after Reg FD because non-relationship lenders face higher information production costs when firms reduce information disclosure. In addition, we also find that borrowers are more dependent on relationship banking; lead lenders retain a larger fraction of the loans they syndicate; the secondary loan bid-ask spread significantly increases following the implementation of Reg FD. We interpret these findings as evidence of increased level of information asymmetry in the credit market.

ABSTRACT (Click Here for Paper) The headline numbers appear to show that even as banks and financial intermediaries suffered large credit losses in the financial crisis of 2007-09, they raised substantial amounts of new capital, both from private investors and through government-funded capital injections. However, on closer inspection a large part of the newly raised capital came from debt-like hybrid claims such as preferred equity and subordinated debt. The erosion of common equity was exacerbated by large scale payments of dividends especially in the former part of the crisis, in spite of widely anticipated credit losses. Dividend payments represent a transfer from creditors (and potentially taxpayers) to equity holders in violation of the priority of debt over equity. The dwindling pool of common equity in the banking system may have been one reason for the continued reluctance by banks to lend over this period. We draw conclusions on how capital regulation may be reformed in light of our findings.

ABSTRACT (Click Here for Paper) Since the conference version of this report in February 2011, bank stress tests have been almost continuously in the news. In the United States, the Dodd-Frank Act mandates annual stress tests for key institutions. In early 2011, the Federal Reserve conducted the fi rst test under the Act on major banks, and is currently conducting the second test, the results of which will be announced in early 2012. Europe completed a stress test in July 2011 that ignored many principles of this report. Like the prior European tests in 2010, the 2011 version is now deemed to have failed, so that yet another European stress test exercise is contemplated. We offer a framework for evaluating these exercises. The starting point is to contrast micro- and macro-prudential principles for stress tests. Microprudential stress tests emphasize the traditional role of bank capital as a buffer against loss, shielding the deposit insurance agency. The focus is on resolving insolvent banks and on “prompt corrective action” to protect taxpayers. The Basel capital ratio is key. The U.S. savings and loan crisis of the early 1980s is the motivating event. Macroprudential stress tests focus on whether the banking system as a whole has the balance sheet capacity to support the economy. A central goal is averting runs on systemic banks by wholesale creditors that lead to a contraction of credit and damage to the broader economy. To avoid aggregate deleveraging in periods of distress, remedies focus on raising new capital measured in total dollars (or euros), rather than on merely satisfying capital ratios. We argue for the macroprudential approach and propose five principles. First, banks have to be suffi ciently solvent to avert runs. The “run point” of a systemic bank often entails significantly higher capital than the bare solvency point. Second, even solvent banks may be required to refrain from depleting capital if the system as a whole does not meet the higher macroprudential criteria. For shareholders, one dollar inside the bank should be worth more than one dollar in dividends. But, in any case, supervisors should consider more than just private benefits and costs. Had U.S. supervisors suspended dividends in the summer of 2007, $80 billion of capital could have been retained in the 19 banks that were subject to the 2009 Supervisory Capital Assessment Program. That sum is roughly half of the public recapitalization funds that these banks received. Third, the remedy to undercapitalization should be stated in dollar (or euro) amounts, not capital ratios. The objective is to maintain the balance sheet capacity of the banking system as a whole. That capacity depends on the level of equity in the system. After a shock, targeting the ratio of equity to assets invites banks to meet the goal by shedding assets and exacerbating the credit crunch. Fourth, stress scenarios should consider both sides of the balance sheet, and explicitly consider fi re sales, runs by wholesale creditors, common exposures and credit crunch risks. Fifth, liquidity rules, in addition to capital requirements, should be part of the overall framework of macroprudential oversight. By means of an illustrative example, this paper highlights the need for a macroprudential approach, and explains why the potential economic costs are much higher when banks are systemic. We then provide a diagnostic framework using bank equity and CDS prices (and correlations between them) that can help in the formulation of corrective measures. We also review a range of empirical evidence regarding large intermediaries in the light of our framework. Taken together, this evidence suggests that the fi nancial systems in both the United States and Europe remained stressed even in early 2011, well after the crisis peaked: First, based on the level of CDS prices, the default risk of U.S. intermediaries at the onset of the 2009 stress tests was perceived to be much higher than before the crisis. After the U.S. stress test, CDS prices fell substantially, but remained elevated as of early 2011 compared to highly rated non financial companies. European banks also faced elevated CDS prices at the time of the 2010 stress test, and only a few institutions have experienced signifi cant declines, indicating that perceived default risk was persistently high. Second, the correlations between equity returns of intermediaries remained higher after the stress tests than they were in 2006, prior to the crisis. Even banks with less elevated CDS prices show equity returns that are positively correlated with their competitors bearing higher CDS prices. Thus, bad news for one bank is bad news for all. This persistent pattern suggests that, even in early 2011, there were virtually no institutions seen as capable of absorbing weaker organizations in a fi re sale. Otherwise, bad news for weaker fi rms might be viewed as good news for potential saviors. Third, the correlations between equity returns and banks' own-CDS prices remained negative for almost all of the institutions. A substantial negative correlation is to be expected if an institution is thinly capitalized because news that raises the value of its equity will lower the default risk on debt. For well capitalized fi rms, however, this correlation should be weak or non-existent. Finally, the macroprudential perspective also provides important lessons for the 2011 Europe financial crisis. The bulk of the report analyzes the state of conditions in the runup to early 2011. This analysis anticipated the failure of the July 2011 European tests. We have added an epilogue that updates the empirical work to cover the developments in Europe through 2011. We continue to argue that the troubles in Europe will persist until the European banks are capitalized to the degree that they can withstand losses on their sovereign bond holdings without triggering a run or a widespread deleveraging that undermines the supply of credit.

ABSTRACT (Click Here for Paper) The most severe impacts of the financial crisis of 2007-2009 arose immediately after the failure of Lehman Brothers on September 15, 2008. It is natural to wonder whether the United States should have arranged for an orderly rescue of Lehman as it did for Fannie Mae and Freddie Mac the week before and as it did for AIG, Merrill Lynch, Citigroup, Bank of America, Morgan Stanley, Goldman Sachs, Washington Mutual, and Wachovia as well as many smaller and foreign banks over the next days and weeks. How much capital would have been necessary ex post to arrange such an orderly rescue? Another policy recommendation of the Dodd-Frank Act of 2010 is to facilitate orderly liquidation and/ or resolution and require living wills of financial institutions so that no future bailouts will be necessary. Will this work when we need it? There is, however, also a third choice. Rather than discuss whether to rescue or not, it is sensible to regulate ex ante financial institutions whose failure is likely to have major impacts on the financial and real sectors of the economy; for instance, regulate them to reduce their risk, and consequently the probability that taxpayers will face this choice.

ABSTRACT (Click Here for paper) Paper proposes that the Fed auction Federal Liquidity Options (FLOs) as the exclusive means of providing liquidity to nonbanks in a crisis. Having issued FLOs that encompass a sufficient quantity and breadth of collateral, authorities will be able to claim, with credibility, that no additional emergency lending programs or bailouts will be required to safeguard the viability of solvent nonbanks. In the resulting policy regime, the Fed does not rescue individual firms or industries but fulfills its contractual obligations under options previously sold at market-determined prices. Furthermore, with the cost of contingent liquidity internalized by the purchasers of FLOs, and with other extraordinary provisions of liquidity credibly removed, moral hazard will drop significantly.Journal of Applied Finance, Volume 22, No. 2, 2012.

ABSTRACT (Click Here for Paper) What is the effect of financial crises and their resolution on banks' choice of liquidity? When banks have relative expertise in employing risky assets, the market for these assets clears only at pre-sale prices following a large number of bank failures. The gains from acquiring assets at pre-sale prices make it attractive for banks to hold liquid assets. The resulting choice of bank liquidity is counter-cyclical, inefficiently low during economic booms but excessively high during crises. We present evidence consistent with these predictions. While interventions to resolve banking crises may be desirable ex post, they affect bank liquidity in subtle ways: liquidity support to failed banks or unconditional support to surviving banks reduces incentives to hold liquidity, whereas support to surviving banks conditional on their liquid asset holdings has the opposite effect.

ABSTRACT (Click Here for Paper) We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.

ABSTRACT (Click Here for Paper) There is a growing view that systemic risk arises due to loss of intermediation for the overall economy - a negative externality - when the financial sector becomes under-capitalized as a whole. In turn, the systemic risk contribution of an individual financial firm can be defined as its share of this negative externality. Motivated by this intuition, a number of authors have proposed a “Pigovian tax” that would charge each firm in relation to its marginal potential impact on the aggregate risk of the financial sector. This paper discusses and analyzes several measurement strategies that could be used to estimate such systemic risk surcharges. Some empirical evidence is provided which shows how these measurements line up with the loss of capitalization of financial firms during the financial crisis of 2007-2009.

ABSTRACT (Click Here for Paper) Systemic crises tend to erupt when highly leveraged financial institutions are forced to deleverage, sending the economy into recession; leverage is a central element of economic cycles and systemic risk. While traditionally the interest rate has been regarded as the single key feature of a loan, we argue that leverage is in fact a more important measure of systemic risk. We discuss how leverage can be monitored for assets, institutions, and individuals, and highlight the benefits of monitoring leverage. Our main conclusions are: Monitoring leverage is “easy”: Leverage at the asset level can be monitored by recording margin requirements, or, equivalently, loan‐to‐value ratios. This provides a model‐free measure that can be directly observed, in contrast to other measures of systemic risk that require complex estimation. 1)Monitoring leverage is monitoring systemic risk 2)Liquidity crisis management 3)New vs. old leverage

ABSTRACT (Click Here for Paper) Two forces have reshaped global securities markets in the last decade:Exchanges operate at much faster speeds and the trading landscape hasbecome more fragmented. In order to analyze the positive and normativeimplications of these evolutions, we study a framework that captures (i)exchanges' incentives to invest in faster trading technologies and(ii) investors' trading and participation decisions. Our modelpredicts that regulations that protect prices will lead to fragmentationand faster trading speed. Asset prices decrease when there isintermediation competition and are further depressed by priceprotection. Endogenizing speed can also change the slope of asset demandcurves. On normative side, we find that for a given number of exchanges,faster trading is in general socially desirable. Similarly, for a giventrading speed, competition among exchange increases participation andwelfare. However, when speed is endogenous, competition betweenexchanges is not necessarily desirable. In particular, speed can beinefficiently high. Our model sheds light on important features of theexperience of European and U.S. markets since the implementation ofMiFID and Reg. NMS, and provides some guidance for optimal regulations.

ABSTRACT (Click Here for Paper) Recently, Friedrich Hayek's classic The Road to Serfdom, a warning against the dangers of excessive state control, was the number one best seller on Amazon. At the same time, the foundation of much modern economics and capitalism—Adam Smith's The Wealth of Nations—languished around a rank of 10,000. It is a telling reflection of the uncertain times we are in that precisely when confidence in free markets is at its all-time low, skepticism about the ability of governments and regulation to do any better is at its peak. So it is no trivial task for the United States Congress and the Obama administration to enact the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and convince a skeptical public that financial stability will be restored in the near future. The Act is widely described as the most ambitious and far-reaching overhaul of financial regulation since the 1930s. Together with other regulatory reforms introduced by the Securities and Exchange Commission (SEC), the Federal Reserve (the Fed), and other regulators in the United States and Europe, it is going to alter the structure of financial markets in profound ways. In this Prologue, we provide our overall assessment of the Act in three different ways: from first principles in terms of how economic theory suggests we should regulate the financial sector; in a comparative manner, relating the proposed reforms to those that were undertaken in the 1930s following the Great Depression; and, finally, how the proposed reforms would have fared in preventing and dealing with the crisis of 2007 to 2009 had they been in place at the time.

ABSTRACT (Click Here for Paper) In the wake of the U.S. housing bubble and collapse and the consequent financial collapse of 2007-2009 and its severe consequences for the U.S. economy, it is unsurprising that there have been calls for policy makers to prevent future asset price bubbles - through the better exercise of monetary policy and/or financial regulatory policy. This essay focuses on financial regulation and argues that such efforts would, at best, be ineffective and, at worst, could squelch productive and efficient asset pricing. Instead, policy makers should focus on better regulatory efforts - better prudential regulation - to ameliorate the consequences of asset bubble deflations on the financial sector.

ABSTRACT (Click Here for Paper) We analyze asset-backed commercial paper conduits, which experienced a shadow-banking “run” and played a central role in the early phase of the financial crisis of 2007-09. We document that commercial banks set up conduits to securitize assets worth $1.3 trillion while insuring the newly securiitized assets using explicit guarantees. We show that regulatory arbitrage was the main motive behind setting up conduits: the guarantees were structured so as to reduce regulatory capital requirements, more so by banks with less capital, and while still providing recourse to bank balance sheets for outside investors. Consistent with such recourse, we find that conduits provided little risk transfer during the "run" : losses from conduits remained with banks rather than outside investors and banks with more exposure to conduits had lower stock returns.

ABSTRACT (Click Here for Paper) Governments often have short-term horizons and are focused excessively on the level of current economic activity, disregarding whether financial-sector regulation designed to achieve it leads to long-term instability. Their short-term objective can be well served through policies governing competition and risk taking in the financial sector. By allowing excessive competition, providing downside guarantees, and encouraging risky lending for populist schemes, governments can create periods of intense economic activity fueled by credit booms. This way, governments effectively operate as “shadow banks” in the financial sector, a moral hazard that can have even more adverse consequences than risk-taking incentives of the financial sector. This government role appears to have been at the center of recent boom and bust cycles, especially in the housing sector in the United States through the presence of government-sponsored enterprises (Fannie Mae and Freddie Mac), and continues to pose a threat to financial stability.

ABSTRACT (Click Here for Paper) The debt capacity of an asset is the maximum amount that can be borrowed using the asset as collateral. We model a sudden collapse in the debt capacity of good collateral. We assume short term debt that must be frequently rolled over, a small transaction cost of selling collateral in the event of default, and a small probability of meeting a buy-to-hold investor. We then show that a small change in the assets fundamental value can be associated with a catastrophic drop in the debt capacity, the kind of market freeze observed during the crisis of 2007-08.

ABSTRACT (Click Here for Paper) We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back to the financial sector, reducing the value of its guarantees and existing bond holdings as well as increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between financial and sovereign credit risk using data on the credit default swaps (CDS)of the Euro zone countries and their banks for 2007-11. We show that the announcement of financial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk.

ABSTRACT (Click Here for Paper) We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank's shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy—a buffer for the regulator's own “model risk” in calculations of needed capital buffers.

ABSTRACT (Click Here for Paper) One “narrative” of the financial crisis of 2007-2009 is that poor corporate governance at financial institutions was a major cause of the crisis. An immediate implication of this narrative is that better corporate governance a better alignment of the interests of senior management with the interests of their shareholders - would have prevented (or at least ameliorated) the crisis. This chapter argues that this corporate governance narrative is largely misguided and reflects an inadequate understanding of modern finance and financial theory. Because of the protections of limited liability, it is in the interests of diversified shareholders of a corporation (including financial institutions) to encourage senior managers to undertake greater risks than is in the interests of the corporation's creditors (or of regulators who may represent depositor creditors or the interests of society more generally). Consequently, public policy should look to improved prudential regulation, rather than improved corporate governance, for restraining the excessively risky activities of systemically important financial institutions.

ABSTRACT (Click Here for Paper) The “government-sponsored enterprise” (GSE) system of residential mortgage finance is clearly broken. But what will replace it remains an unanswered question. This paper lays out a vision for how private markets would if given the opportunity replace the GSEs and provide a fully functioning secondary market for residential mortgages. In the event that the private sector is deemed inadequate for the task, this paper also proposes a “side-by-side” private/government form of mortgage guarantee that would be superior to the “tail risk” or “catastrophe” government insurance proposals that have circulated as alternatives to the GSEs.

ABSTRACT (Click Here for Paper) Systemic risk can be broadly thought of as the failure of a significant part of the financial sector one large institution or many smaller ones leading to a reduction in credit availability that has the potential to adversely affect the real economy. Given the interconnectedness of the modern financial sector, and for the purposes of systemic regulation, one should think of a “financial firm” as not just the commercial bank taking deposits and making loans, but also include investment banks, money-market funds, insurance firms, and potentially even hedge funds and private equity funds.2 There are several types of systemic risk that can be generated from the failure of a financial institution, and especially so during a financial crisis, such as counterparty risk, spillover risk due to forced asset sales, increased cost of inter-bank borrowing, and the risk of “runs” on the shadow banking system.

ABSTRACT (Click Here for Paper) We analyze the financial crisis of 2007-2009 through the lens of market failures and regulatory failures. We present a case that there were four primary failures contributing to the crisis: excessive risk-taking in the financial sector due to mispriced government guarantees; regulatory focus on individual institution risk rather than systemic risk; opacity of positions in financial derivatives that produced externalities from individual firm failures; and runs on the unregulated banking sector that eventually threatened to bring down the entire financial sector. In emphasizing the role of regulatory failures, we provide a description of regulatory evolution in response to the panic of 1907 and the Great Depression, why the regulation put in place then was successful in addressing market failures, but how, over time, especially around the resolutions of Continental Illinois, Savings and Loans crisis and the Long-Term Capital Management, expectations of too-big-to-fail status got anchored. We propose specific reforms to address the four market and regulatory failures we identify, and we conclude with some lessons for emerging markets.

ABSTRACT (Click Here for Paper) The central role that the three large U.S.-based rating agencies played in the subprime mortgage lending debacle and the subsequent financial crisis has led to expanded regulation of the rating agencies and political calls for considerably more regulation. The advocates of this policy route, however, ignore the history of how the rating agencies came to occupy a central place in the provision of bond creditworthiness information; and they ignore the dangers that more regulation will raise the barriers to entry into and decrease innovation in the provision of bond creditworthiness information. A better policy route would be to reduce the regulation of the rating agencies while reforming the prudential regulation of financial institutions' bond portfolios, by eliminating regulatory reliance on ratings. This would allow financial institutions to obtain their bond creditworthiness information from a wider range of sources, which would encourage new methodologies, new technologies, new procedures, and possibly even new business models. Since the transactors in bond markets are predominantly institutional bond managers, less regulation of the information providers would be appropriate.

ABSTRACT We argue that the fundamental cause of the financial crisis of 2007-09 was that large, complex financial institutions (“LCFIs”) took excessive leverage in the form of manufacturing tail risks that were systemic in nature and inadequately capitalized. We employ a set of headline facts about the build-up of such risk exposures to explain how and why LCFIs adopted this new banking model during 2003-2Q 2007, relative to earlier models. We compare the crisis to other episodes in the United States, in particular, the panic of 1907, the failure of Continental Illinois and the Savings and Loan crisis. We conclude that several principal imperfections, in particular, distortions induced by regulation and government guarantees, developed in decades preceding the current one, allowing LCFIs to take on excessive systemic risk. We also examine alternative explanations for the financial crisis. We conclude that while moral hazard problems in the originate-and-distribute model of banking, excess liquidity due to global imbalances and mispricing of risk due to behavioral biases have some merit as candidates, they fail to explain the complete spectrum of evidence on the crisis.

ABSTRACT (Click Here for Paper) The financial crisis of 2007-09 was, of course, triggered by the puncture of a great housing bubble that had been inflated by mortgage lenders and their agents. And while the full story of this debacle (like every story involving trillions of dollars in capital) is complicated, its outline is pretty straightforward. When home prices began to slip after peaking in mid-2006, a trickle and then a flood of borrowers defaulted on their mortgage payments. This generated losses for lenders and, in turn, the owners of securities that had been backed by those mortgages. A few very large investment banks and commercial banks figured prominently among the ranks of those owners. And their thin capital proved inadequate to absorb the losses, bringing the global financial system to the brink of a true collapse that was prevented only by massive government intervention.

ABSTRACT (Click Here for Paper) The descent of Chrysler and General Motors into bankruptcy threatens the Chapter 11 reorganization process itself. In each case, a judge approved a transfer of a debtor's assets to favored creditors under circumstances where holders of other claims were denied basic safeguards. Legal reform is required, and proposed here, to assure that aggrieved creditors are granted protection either of the marketplace or of the Bankruptcy Code's creditor democracy provisions. Such reform could help minimize the cost of capital faced by future debtors.

ABSTRACT (Click Here for Paper) The three large U.S.-based credit rating agencies - Moody's, Standard & Poor's, and Fitch provided excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade actions that played a central role in the financial debacle of the past two years. The strong political sentiment for heightened regulation of the rating agencies as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) - is understandable, given this context and history. The hope, of course, is to forestall future such debacles.

ABSTRACT (Click Here for Paper) The U.S. financial crisis of 2007-2008 has been a searing experience. The popping of a housing bubble exposed the subprime lending debacle, which in turn created a wider financial crisis. In its response to this crisis, the federal government has provided financial assistance to a number of financial institutions that are often described as “too big to fail” (TBTF) - which, to those who associate antitrust with size, seems to bring antitrust potentially into the picture. This paper will offer a guide to the antitrust community that will cover the U.S. financial sector, financial regulation, and the debacle and subsequent financial crisis. The tensions that can arise between financial regulation and antitrust will be highlighted. TBTF is not one of them, however, because TBTF is about size and interconnectedness, but not about competition and market power. Although much progress has been made in removing anti competitive elements from financial regulation over the past three to four decades, there are still important advances that can be made. The paper concludes by offering a set of policy recommendations for the removal of some of the important remaining elements of financial regulation that impede competition.

ABSTRACT (Click Here for Paper) The Gramm-Leach Bliley Act (GLBA), which was hailed at the time of its enactment in 1999, has recently been flailed by critics who claim that it was a major cause of the financial crisis of 2007-2009. These critics often call for a revival of the Glass-Steagall barriers between commercial banking and investment banking, which the GLBA largely eliminated. The so-called Volcker Rule is a recent manifestation of this anti-GLBA sentiment. After reviewing the Glass-Steagall Act of 1933 and related subsequent developments, this paper discusses the enactment of GLBA and demonstrates that the GLBA and little or nothing to do with the crisis and thus that a re-enactment of the Glass Steagall barriers or enactment of the Volcker Rule would not prevent future such barriers. The paper argues that the GLBA's erection of a new barrier to a non-financial firm's ownership of a depository institution was misguided. Thus, in an important sense, the GLBA did not go far enough in breaking down barriers.

ABSTRACT (Click Here for Paper) The Federal Home Loan Bank (FHLB) System is a very large, but relatively unknown, cooperatively owned government sponsored enterprise (GSE) that is charged with assisting its owner/members to finance housing and some community lending. After an introductory overview of the FHLB System, this chapter summarizes the 77-year history of the System, including the evolution of this institution's structure, public mission, and activities. Building on this background, we then conduct an evaluation of the public policy question of the expansion of the FHLBs' authorization to issue standby letters of credit. We further examine the role, actions, and stresses of the FHLB System in the context of the current financial crisis, as well as outlining some possibilities for the System in the post-crisis U.S. financial structure.

ABSTRACT (Click Here for Paper) While systemic risk the risk of wholesale failure of banks and other financial institutions is generally considered to be the primary reason for supervision and regulation of the banking industry, almost all regulatory rules treat such risk in isolation. In particular, they do not account for the very features that create systemic risk in the first place, such as correlation among banks' investments (Acharya 2009; Acharya and Yorulmazer 2007, 2008); the large size of some banks (O'Hara and Shaw 1990),1 which leads to “fire sale”-related pecuniary externalities; and bank interconnectedness (Allen and Gale 2000; Kahn and Santos 2005). In this paper, we aim to fill this important gap in the design of regulatory tools by providing a normative analysis of how deposit insurance premiums could best be structured to account for systemic risk.

ABSTRACT (Click Here for Paper) We consider four different approaches to the resolution of distress or failure of large, complex financial institutions (LCFI): (1) laissez-faire or market-based; (2) regulatory forbearance; (3) receivership in hands of government or government-appointed regulator; and, (4) distressed exchanges. We investigate several criteria for evaluating these approaches, including which method works best in liquidity versus fundamental crises, the difficulty with managing failed institutions and the resulting systemic risk, the issue of moral hazard and its impact on future crises, and the impact on taxpayers. While a market-based approach helps resolve insolvent institutions and provides discipline, it may not work well in dealing with systemic risk during a crisis. Regulatory forbearance achieves almost the opposite outcome, simply blunting systemic spillovers during a crisis but at the cost of severe moral hazard. On balance, we find most attractive the receivership approach with temporary transfer of ownership to a resolution authority that provides an orderly restructuring and liquidation (if needed) of the distressed LCFI's. While distressed exchanges also offer a market-based solution that would prevent moral hazard, there remain question marks around their swift implementation for LCFI's and especially their vulnerability to sparking contagious runs on other LCFI's.

ABSTRACT (Click Here for Paper) Proposes new policies for assessing premiums on deposit insurance. 1) The actuarially fair deposit insurance premium-- the premium that exactly covers the expected cost to the deposit insurance provider-- should not only increase in relation to individual bank failure risk but also in relation to joint bank failure risk. 2) The premium for large banks should be higher per dollar of insured deposit compared with that for small banks. 3) The incentive-efficient premium that discourages banks from excessive correlation in their investments features a higher charge for joint bank failure risk than the actuarially fair premium.Federal Reserve Bank of New York Economic Policy Review, 16:1, 2010.

ABSTRACT (Click Here for Paper) The global imbalance explanation of the financial crisis of 2007-09 suggests that demand for riskless assets from countries with current account surpluses created fragility in countries with current account deficits, most notably, in the United States. We examine this explanation by analyzing the geography of asset-backed commercial paper (ABCP) conduits set up by large commercial banks. We show that both banks located in surplus countries and banks located in deficit countries manufactured riskless assets of $1.2 trillion by selling short-term ABCP to risk-averse investors, predominantly U.S. money market funds, and investing the proceeds primarily in long-term U.S. assets. As negative information about U.S. assets became apparent in August 2007, banks in both surplus and deficit countries experienced difficulties in rolling over ABCP and as a result suffered significant losses. We conclude that global banking flows, rather than global imbalances, determined the geography of the financial crisis.

ABSTRACT (Click Here for Paper) This paper exposes a fundamental tension between the micro-prudential objective of subjecting banks to greater discipline through debt markets and the macro-prudential objective of containing systemic risk. We show that banks are illiquid due to the inability of bankers to credibly pre-commit to asset choices. Bank debt can reduce this illiquidity by disciplining bankers with the threat of premature liquidations. However, the liquidation of a bank's assets leads creditors of other banks to update their priors on common shocks affecting asset values, giving rise to contagion and liquidations throughout the system. Thus, liquidity creation induced by the disciplining role of bank debt has the benefit of generating more information about common asset-value shocks, but it comes at the cost of greater systemic risk, risk that is not fully internalized by banks in choosing privately optimal levels of leverage. We then consider implications of a lender of last resort (LOLR) that intervenes to bail out banks when faced with the prospect of a contagion. While LOLR interventions can diminish the incidence of contagion and thereby reduce systemic risk, they also carry the misfortune of eliminating efficient liquidations. . In particular, by reducing creditor incentives to intervene in banks, the LOLR can preclude the discovery of "early warnings" of a banking crisis and risk the emergence of a delayed but more severe crisis.

ABSTRACT (Click Here Paper) There are four pillars of effective regulatory architecture that are common across all financial systems. Good architecture should (1) encourage innovation and efficiency, (2) provide transparency, (3) ensure safety and soundness, and (4) promote competitiveness in global markets. Efforts to pursue these objectives at the same time inevitably create difficult policy trade-offs. Measures that assure greater financial robustness may make financial intermediation less efficient or innovative, for example. Efforts to promote financial innovation may erode transparency, safety, and soundness. Competitive pressure among financial centers may trigger a race to the bottom in terms of systemic robustness to internal and external shocks. Unfortunately, benchmarks underlying the financial architecture, on which it is easy to find agreement, are far more difficult to define in detail and even more difficult to calibrate in practice. We know that excessive regulation involves costs, but what are they? We also know that under regulation can unleash disaster, which can be observed only after the fact. So optimum regulation is the art of balancing the immeasurable against the unknowable. It is not surprising that financial crises are a recurrent phenomenon. In this chapter we spell out the practical alternatives for financial regulation and identify the nature of their impact on key attributes of financial products, markets, and firms. We then narrow the range of regulatory options to those contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and comparable regulatory initiatives around the world, and assess them in light of the four pillars of regulatory architecture underlying a financial system that successfully serves the public interest.

ABSTRACT (Click Here for Paper) Derivatives exposures across large financial institutions often contribute to if not necessarily create systemic risk. During a crisis, lack of adequate understanding of such exposures often compromises regulatory ability to unwind an institution, inducing large-scale backstops and counterparty bailouts. It is often argued in spite of the massive assistance that was provided in this crisis to deal with derivatives exposures that derivative contracts are well collateralized so that counterparty risk is not a significant issue (on derivatives exposures). While this may have been true in some cases, evidence suggests otherwise in many important cases that contributed to the crisis. 2 Equally importantly, documenting such evidence beyond reasonable doubt is currently infeasible due to the poor quality of derivatives disclosures by financial institutions to regulators and to the public at large. Furthermore, a lack of standardization of existing disclosures aggravates the problem of obtaining any consistent inference across institutions.

ABSTRACT (Click Here for Paper) Paper argues that loans provided by central banks can be a more powerful tool for lowering yields and stimulating economic activity than reducing the interest rate. Reducing the interest rate decreases the required returns of low-haircut assets but may increase those of high-haircut assets, since it may increase the shadow cost of capital for constrained agents. A reduction in the haircut of an asset unambiguously lowers its required return and can ease the funding constraints on all assets.NBER Macroeconomics Annual, 2010.

ABSTRACT (Click Here for Paper) We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be under capitalized when the system as a whole is under capitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are taxed based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the financial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large financial firms in the crisis; and, (iii) the widening of their credit default swap spreads.

ABSTRACT (Click Here for Paper) This paper investigates the short selling of financial company stocks around the time of the SEC September 2008 short-selling ban. More specifically, this paper examines whether this short selling, mainly by hedge funds and other types of sophisticated investors, was purely speculative or whether it was driven by rational behavior in response to a financial company's risk exposure, such as its holdings of subprime-related assets and its credit risk exposure. Our results show that during the crisis period the short-selling of financial firms stock was not significantly greater than that of non-financial firms, even after controlling for size and risk. More importantly, our results show that short sellers rationally short sold those financial company stocks with the greatest subprime and insolvency risk exposures. This finding has important implications regarding banning short selling, since it suggests that such a regulation may mute the disciplining effects of investors in the financial market on those financial companies with the greatest risk exposures and would be contrary to the intentions of bank regulators who have emphasized an increased reliance on market discipline.

ABSTRACT (Click Here for Paper) The recent financial crisis has raised concerns that the failure of a significant derivatives' counterparty and the liquidation of its positions might surprise and disrupt markets to the extent of threatening the viability of otherwise solvent institutions. To reduce this systemic risk, a policy consensus seems to have emerged around two objectives. One, ensure that positions held in derivatives markets are transparent to regulators and, in some aggregated form, to the public. Two, channel as many derivatives trades as practicable through clearing houses. The implementation of these objectives, however, is far from straightforward. Exactly which positions have to be reported and cleared? What are the consequences of inaccurate or incomplete reporting or of failing to clear trades? Exactly which services constitute “clearing”? Existing legislative and regulatory initiatives do not answer these questions satisfactorily, partly because the broad policy objectives have not been thought through in the context of particular markets and partly because of a reflexive preference to rely on mandates rather than incentives. This paper recommends implementing the transparency and clearing objectives by narrowing the safe harbor for derivatives (i.e., the right to close-out derivative trades with counterparties that have declared bankruptcy) to include only those trades that are cleared, where “clearing” is meant to mandate only third-party pricing and collateral management.

ABSTRACT (Click Here for Paper) This paper begins with an overview of the practice of audits, the auditing profession, and the problems that auditors continue to face in terms not only of providing audits of high quality, but also in providing audits that investors feel comfortable trusting to be of high quality. It then turns to a number of reforms that have been proposed, including ways of building reputation, liability reform, capitalizing or insuring auditing firms, and greater competition in the auditing profession. However, none of these suggested reforms, individually or collectively, severs the agency relation between the client management and the auditors. As a result, the conflict of interest, although it can be mitigated by some of these reforms, continues to threaten auditors' independence, both real and perceived. In conclusion, I'll discuss my own proposal for “financial statements insurance,” which would redefine the relationship between auditors and firms in such a way that auditors would no longer be beholden to management.

ABSTRACT (Click Here for Paper) This paper first explains how the design of the tri-party repo system, while solving various operational problems in the secured funding markets, actually creates significant systemic risk. More precisely, by giving broker-dealers use of their security collateral during the day the system effectively transfers the intra-day risk of a broker-dealer default from many secured lenders to the two clearing banks. This paper then argues that imposing capital requirements and risk charges on this intraday risk will force the industry to correct the existing systemic risk on its own. Furthermore, as an added benefit, these requirements and charges will, by leveling the playing field in the provision of services to the secured funding market, spur competition and innovation. Finally, this paper argues that the alternate policy proposals mentioned above will not be as effective in stabilizing and strengthening the secured funding market.

ABSTRACT By means of the high ratings that they awarded to subprime mortgage‐backed bonds, the three major rating agencies Moody's, Standard & Poor's, and Fitch played a central role in the current financial crisis. Without these ratings, it is doubtful that subprime mortgages would have been issued in such huge amounts, since a major reason for the subprime lending boom was investor demand for high‐rated bonds much of it generated by regulations that made such bonds mandatory for large institutional investors. And it is even less likely that such bonds would have become concentrated on the balance sheets of the banks, for which they were rewarded by capital regulations that tilted toward high‐rated securities. Why, then, were the agencies excessively optimistic in their ratings of subprime mortgage‐backed securities? A combination of their fee structure, the complexity of the bonds that they were rating, insufficient historical data, some carelessness, and market pressures proved to be a potent brew. This combination was enabled, however, by seven decades of financial regulation that, beginning in the 1930s, had conferred the force of law upon these agencies' judgments about the creditworthiness of bonds and that, since 1975, had protected the three agencies from competition.

ABSTRACT (Click Here for Paper) The US financial services sector is heavily regulated. The regulatory structure is quite complicated, with a myriad of regulatory agencies and overlapping responsibilities. This structure is daunting and confusing, and it has its costs and complications. However, a great advantage to this complicated and duplicative system is that it gives someone with an innovative idea more than one place to turn; there is no monopoly regulator. Although there are periodic calls for simplifying the system, a major cost from simplification would be this reduced choice, and consequent reduced innovation.

ABSTRACT (Click Here for Paper) Why did the popping of the housing bubble bring the financial system rather than just the housing sector of the economy to its knees? The answer lies in two methods by which banks had evaded regulatory capital requirements. First, they had temporarily placed assets such as securitized mortgages in off-balance-sheet entities, so that they did not have to hold significant capital buffers against them. Second, the capital regulations also allowed banks to reduce the amount of capital they held against assets that remained on their balance sheets if those assets took the form of AAA-rated tranches of securitized mortgages. Thus, by repackaging mortgages into mortgage backed securities, whether held on or off their balance sheets, banks reduced the amount of capital required against their loans, increasing their ability to make loans many-fold. The principal effect of this regulatory arbitrage, however, was to concentrate the risk of mortgage defaults in the banks and render them insolvent when the housing bubble popped.

ABSTRACT (Click Here for Paper) With governments beginning to implement new financial regulation, the G20 in its recent Pittsburgh summit laid out four principles they will coordinate on: 1. Building high quality capital and mitigating pro-cyclicality; 2. Improving over-the-counter derivatives markets; 3. Arranging better plans for the resolution of cross-border and systemically important financial institutions by end-2010; 4. Reforming compensation practices to support financial stability.

ABSTRACT (Click Here for Paper) We provide a model that links an asset's market liquidity (i.e., the ease with which it is traded) and traders' funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and margin requirements, depends on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality,” and (v) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums.

ABSTRACT ( Click Here for Paper) Commercial paper is one of the largest money market instruments and has long been viewed as a safe haven for investors seeking low risk. However, during the financial crisis of 2007-2009, the commercial paper market experienced twice the modern-day equivalent of a bank run with investors unwilling to refinance maturing commercial paper. We analyze the supply of and demand for commercial paper and show that, in contrast to previous turbulent episodes, the crisis centered on commercial paper issued by, or guaranteed by, financial institutions. We describe the importance of Federal Reserve's interventions in restoring stability of the market. Finally, we propose three possible explanations for the sharp decline of the commercial paper market: substitution to alternative sources of financing by commercial paper issuers, adverse selection, and institutional constraints among money market funds.

ABSTRACT The application in July 2005 by Wal-Mart to obtain a specialized bank charter from the state of Utah and to obtain federal deposit insurance reopened a national debate concerning the separation of banking and commerce. Though Wal-Mart withdrew its application in March 2007, the issue and the debate continue. This article offers a principles-based approach to this issue that begins with the recognition that banks are special and that safety and soundness regulation of banks is therefore warranted. Building on that recognition, the article lays out the principle that the “examinability and supervisability” of an activity should determine if that activity should be undertaken by a bank. Even if an otherwise legitimate activity is not suitable for a bank, it should be allowed for a bank's owners (whether the owners are individuals or a holding company), so long as the financial transactions between the bank and its owners are closely monitored by bank regulators. The implications of this set of ideas for the Wal-Mart case and for banking and commerce generally are then discussed.

ABSTRACT (Click Here for Paper) In the run-up to the financial crisis of 2007-2008, market participants relied heavily on the ratings that credit rating agencies assigned to financial instruments, including mortgage-backed securities, to determine creditworthy investment options. As mortgage holders began to default on their loans and many highly rated securities lost value, the poor quality of these ratings became apparent. Policy makers pondering financial regulatory changes to avoid future catastrophes should understand how regulatory actions facilitated a noncompetitive credit rating industry and propelled its members into the center of the bond information process, which in turn contributed to the financial crisis of 2007-2008.

ABSTRACT (Click Here for Paper) This paper presents a discussion of the key issues facing the financial regulation of insurance companies in the post-crisis era. While the moral hazard created in the financial sector by provision of financial guarantee insurance is difficult to overstate, we focus on the issues concerning insurers' excessive provision of insurance, under-capitalization, and related systemic risks. We argue that these systemic risks stem from a too interconnected to fail problem, manifested most perversely in the case of A.I.G. We provide a way to measure the systemic risk contributions of insurers based on market data and calculate this measure (called Marginal Expected Shortfall or MES) for insurers in the United States during the period 2004-2007. We show that several insurers ranked highly on this measure compared to systemically risky banks over this period.

ABSTRACT (Click Here for Paper) The dangers of shouting "fire" in a crowded theater are well understood, but the dangers of rushing to the exit in the financial markets are more complex. Yet, the two events share several features, and I analyze why people crowd into theaters and trades, why they run, what determines the risk, whether to return to the theater or trade when the dust settles, and how much to pay for assets (or tickets) in light of this risk. These theoretical considerations shed light on the recent global liquidity crisis and, in particular, the quant event of 2007.

ABSTRACT (Click Here for Paper) The 2007-2008 financial debacle has raised many questions as to whether the Community Reinvestment Act (CRA) played a facilitating role. Congress enacted the CRA in 1977 in response to the belief that low and moderate income (LMI) communities needed expanded access to credit. This legislation is a regulatory effort to “lean on” banks and savings institutions in vague and subjective ways to make loans and investments that (CRA proponents believe) those depository institutions would otherwise not make. Although the goals for promulgating the CRA were well intended and the CRA was not instrumental in the current subprime mortgage driven debacle, the CRA is not good public policy.

ABSTRACT (Click Here for Paper) This paper reexamines the separation of commercial and investment banking in the context of modern wholesale financial environment, dominated by a small cohort of “systemic” institutions. The paper traces the pathology of regulation and deregulation from the watershed events of the 1930s to the systemic financial failures of the recent past. It then considers the structure, conduct and performance of the wholesale financial industry and how firms that cannot be allowed to collapse get that way. Based on the industrial organization of global wholesale finance, the paper then examines the available regulatory techniques, and makes some judgments as to their relative promise in promoting future financial stability with least possible dislocation of financial efficiency, proposing benchmarks for the calibration of proposals for regulatory reform. The paper then evaluates functional separation and carve outs of high-risk activities that cannot defensibly be conducted within systemic financial firms in the real world of power politics and regulatory capture. The paper concludes that blanket condemnation of the functional separation features of the 1930s financial reforms is unwarranted in the light of ongoing experience, and that it is time to revisit this issue in reconfiguring the global wholesale financial architecture.

ABSTRACT (Click Here for Paper) If someone had shouted “financial regulation” in a crowded auditorium a year ago, nary a soul would have stirred. No more, of course. An overhaul of the rules that Wall Street and its friends must live by is near the top of the Obama administration's must-do list. To paraphrase Rahm Emanuel, the presidentelect's choice for White House chief of staff, the country's new leaders aren't about to let a perfectly good debacle go to waste. But with the fate of what has become America's vanguard industry at stake, untangling the web we've been weaving and reweaving since the 1930s isn't a matter to be done casually. Herewith, a primer on what to hope for.

ABSTRACT (Click Here for Paper) The U.S. economic crisis is systemic but the system is so complicated that commentators, policy makers, and the general public are focusing on details rather than on the big picture. This article offers a different perspective: An overview of the whole system, as if from 20,000 feet above it, that allows us to see the systemic nature of the crisis without being distracted by its complex details. The primary focus is on the problems with subprime mortgages, and I suggest a general approach to defuse that major driver of the crisis. But conditions have worsened so quickly since September 2008 that actions, which might have arrested the decline at that time, are now inadequate. However, one central message that it will be hard to get the financial system back on its feet without resolving the problems in the mortgage market still holds, and our general approach of government intervention at the point where the real economy risk connects to the financial system still offers a way to do that. And while real estate remains the largest and most disrupted sector of the economy, the principles outlined in this article are potentially applicable to other areas, as well.

ABSTRACT (Click Here for Paper) Many identify inflated credit ratings as one contributor to the recent financial market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings - observe multiple ratings and disclose only the most favorable - before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.

ABSTRACT (Click Here for Paper) During this current financial crisis, the terms “capital” and “leverage” have figured prominently in discussions about the causes of and the possible solutions to alleviate the crisis. They also provide important tools for understanding some of the causes of bank “runs.” This Mercatus on Policy clarifies these concepts as they apply to financial institutions and the debacle of 2007-2008 and explains how these concepts should affect the roles that prudential regulators can play in maintaining the safety and soundness of the banking system.

ABSTRACT (Click Here for Paper) Views about the CRA surely differ from those of many of the other individuals who will contribute to this colloquium. I believe that, despite the good intentions and worthwhile goals of the CRA's advocates, the CRA is an inappropriate instrument for achieving those goals. Fundamentally, the CRA is a regulatory effort to "lean on" banks and savings institutions, in vague and subjective ways, to make loans and investments that (the CRA's proponents believe) those depository institutions would otherwise not make. It is a continued effort to preserve old structures in the face of a modernizing financial economy. At base, the CRA is an anachronistic and protectionist effort to force artificially a local focus for finance in an increasingly competitive, increasingly electronic, and ever-widening realm of financial services.

ABSTRACT (Click Here for Paper) There has been much debate about the current banking crisis, but less attention has been paid to the capital budgeting practices at banks and the adverse manner in which mispriced government guarantees have played a role. Viral Acharya, Professor of Finance at London Business School and Stern School of Business, New York, and Julian Franks, Oxera Director and Professor of Finance at London Business School, give their perspective.

ABSTRACT Fair value is considered here with respect to the two primary objectives of financial statements proposed in the joint conceptual framework that is under development by the FASB and the IASB, namely (a) informativeness to assist providers of capital in predicting, evaluating, and comparing the amounts, timing and uncertainty of future cash flows, and (b) stewardship - to assist in evaluating how efficient and effective managers have been in enhancing shareholders value. More specifically, a comprehensive set of accounting measures and a set of corporate governance reforms intended to align corporate insiders and auditors behaviour and decisions with the interests of investors is outlined. Suggested reforms show how to present a mix of effectively historical quantifications, exit values, and the discounted values of future cash flows expected from the particularized use of combinations of assets within the firm. Additionally, the article describes how markets can be reformed in order to align the interests of the officers who prepare such accounts, and the auditors who certify them, with those of investors. These market-based reforms would require auditors to insure misrepresentations, and managers to take equity to induce truthful reporting. Also included is a radical extension to earlier proposals by the author, requiring an officer of the company to make the market in shares in a way that would place limits upon the value of the insider's private information.

ABSTRACT (Click Here for Paper) Mandatory disclosure is a regulatory tool intended to allow market participants to assess operational risk. We examine the value of disclosure through the controversial SEC requirement, since overturned, which required major hedge funds to register as investment advisors and file Form ADV disclosures. Leverage and ownership structures suggest that lenders and equity investors were already aware of operational risk. However, operational risk does not mediate flow-performance relationships. Investors either lack this information or regard it as immaterial. These findings suggest that regulators should account for the endogenous production of information and the marginal benefit of disclosure to different investment clienteles.

ABSTRACT (Click Here for Paper) In this history of the first decade of ECB policy, we also discuss key challenges for the next decade. Beyond the ECB's track record and an array of published critiques, our analysis relies on unique source material: extensive interviews with current and former ECB leaders and with other policymakers and scholars who viewed the evolution of the ECB from privileged vantage points. We share the assessment of our interviewees that the ECB has enjoyed many more successes than disappointments. These successes reflect both the ECB's design and implementation. Looking forward, we highlight the unique challenges posed by enlargement and, especially, by the euro area's complex arrangements for guarding financial stability. In the latter case, the key issues are coordination in a crisis and harmonization of procedures. As several interviewees suggested, in the absence of a new organizational structure for securing financial stability, the current one will need to function as if it were a single entity.

ABSTRACT (Click Here for Paper) The plan I have just sketched out would calm the mortgage market which has been the main driver in destabilizing the financial system. It would also turn the toxic securities that are causing large actual losses and much larger uncertainty among financial institutions, and which are paralyzing the credit markets, into benign government backed securities. It would treat homeowners and mortgage lenders fairly. And the drain on the US budget would be relatively limited. It could even end up being nearly costless if the housing market settles down within a few years. The plan would also have important benefits for the housing market. First, it would eliminate the severe human cost of evicting families from their homes. Second, it would eliminate the pressure on the real estate market from foreclosed homes being liquidated at fire sale prices because that is the only way for the lenders to recover any value from the defaulted mortgages. This process has very pernicious effects on home values, both for the lenders who want to recover as much of their investments as possible and also for any homeowner who simply needs to sell a house. Third, it would eliminate the collateral damage on neighborhoods and communities where a significant number of properties stand empty after a foreclosure.

ABSTRACT (Click Here for Paper) We argue that when bankruptcy code is creditor-friendly, excessive liquidations cause levered firms to shun innovation, whereas by promoting continuation upon failure, a debtor friendly code induces greater innovation. We provide empirical support for this claim by employing patents as a proxy for innovation. Using time-series changes within a country and cross-country variation in creditor rights, we confirm that a creditor-friendly code leads to lower absolute level of innovation by firms as well as relatively lower innovation by firms in technologically innovative industries. When creditor rights are stronger, technologically innovative industries employ relatively less leverage and grow disproportionately slower.

ABSTRACT (Click Here for Paper)
This paper provides a model of the interaction between risk-management practices and market liquidity. Our main finding is that a feedback effect can arise. Tighter risk management leads to market illiquidity, and this illiquidity further tightens risk management.

ABSTRACT (Click Here for Paper) As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in ‘cash-in-the-market' pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a policy that involves liquidity assistance to surviving banks in the purchase of failed banks and that is equivalent to the bailout policy from an ex-post standpoint. Crucially, the liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.

ABSTRACT (Click Here for Paper) The Securities and Exchange Commission continues to struggle with mutual fund and corporate governance issues and with disputes as to whether the Sarbanes-Oxley Act went too far or not far enough. There is another important domain of the sec, however its regulation of the bond rating industry where recent legislation has significantly changed the landscape and offers the possibility of a more open regulatory regime and a more competitive industry. Unfortunately, progress is not a foregone conclusion. With little fanfare last September, President Bush signed the Credit Rating Agency Reform Act of 2006. The act could well be as important for the development of U.S. capital markets as any likely reform of Sarbanes-Oxley. Consider the fact that, at the end of September 2006, there was over $8 trillion of corporate, state and local government, and asset-backed structured finance bonds outstanding much of it rated by only a (literal) handful of bond rating companies. A full understanding of the significance of the new law requires a brief recounting of the bond rating industry's history and the sec's haphazard regulation of this industry over the past 31 years.

ABSTRACT (Click here for Paper) This paper draws on the progress that has occurred in other areas of regulation specifically, the "cap-and-trade" program to control SO2 emissions; spectrum auctions; and "dedicated-access-privilege" programs for fisheries to suggest that financial regulation would benefit from an expanded focus on outputs and on markets.

ABSTRACT (Click Here for Paper) This paper discusses the SEC's regulation of the bond rating industry. Until a few years ago this specific branch of SEC regulation was largely unknown outside the agency and the bond rating industry itself, even among knowledgeable Washington insiders. But the SEC has actually regulated the industry since 1975: by limiting entry, in an indirect but powerful way. As a consequence, incumbent bond rating firms are protected; potential entrants are impeded; and new ideas and technologies for assessing the riskiness of debt, and thereby the allocation of capital, may well be stifled. This entry regulation is an excellent example of good intentions having gone awry, via the "law" of unintended consequences. The good intentions were to improve the safety-and-soundness regulation of financial institutions, and even to use "market" information to do so. But the unfortunate result has been a distortionary entry restriction regime with respect to bond rating firms. Fortunately, there are better ways to achieve the desired goals - ways that would permit the SEC to cease these entry restrictions and nevertheless allow safety-and-soundness regulation of financial institutions to proceed in desirable directions. If the SEC were to exit from its role as the entry regulator of the bond rating industry, financial markets' participants could then make their own decisions as to which firms and methods offer the best information as to the default probabilities and other relevant parameters with respect to debt issuances. This paper expands on these themes.

ABSTRACT (Click Here for Paper) The paper overviews the recent debate on the how to reform the sovereign debt restructuring process to make it more orderly. It discusses the market failures in such restructurings and the proposed solutions. These include a sovereign bankruptcy regime, the introduction of collective action clauses in debt contracts and a code of conduct. The current emphasis on the contractual approach is appropriate. But clauses will not resolve all the problems in debt restructurings. Legal reform and litigation are not the central issues that delayed the Argentine restructuring. Thus, the reform agenda should be broadened to ensure that debt crises and restructurings become more orderly.

ABSTRACT (Click Here for Paper) The merit of international convergence of bank capital requirements in the presence of divergent closure policies of di¡erent central banks is examined. The lack of a complementary variation between minimum bank capital requirements and regulatory forbearance leads to a spillover from more forbearing to less forbearing economies and reduces the competitive advantage of banks in less forbearing economies. Linking the central bank's forbearance to its alignment with domestic bank owners, it is shown that in equilibrium, a regression toward the worst closure policy may result: The central banks of initially less forbearing economies also adopt greater forbearance.

ABSTRACT (Click Here for Paper) Recently the debate on the reform of the international financial architecture has centered on the development of an appropriate mechanism or regime to ensure orderly sovereign debt restructurings. Recent cases involving sovereign bonded debt restructuring (those of Ecuador, Pakistan, Russia, and Ukraine) have been successfully completed with the use of unilateral debt exchange offers (complemented by a system of carrots and sticks, such as exit consents, to ensure successful deals). But many observers have expressed dissatisfaction with this “market-based” status quo approach. The IMF has proposed the creation of an international debt restructuring mechanism that would have many of the features of an international bankruptcy regime.1 The papers by Jeremy Bulow, Jeffrey Sachs, and Michelle White are all interesting contributions to this debate. All address the question of whether we need an institutional change in the international financial system that would lead to a new way of providing for orderly sovereign debt restructurings or workouts when they become necessary.

ABSTRACT The design of prudential bank capital requirements interacts with the industrial organization of the banking sector, in particular, with the level of competition among banks. Increased competition leads to excessive risk-taking by banks which may have to be counteracted by tighter capital requirements. When capital requirements are internationally uniform but the levels of competition among banks in different countries are not, international spillovers arise on financial integration of these countries. This result begs a more careful analysis of the effect of financial liberalization on the stability of banking sectors in emerging countries. It also calls into question the merits of employing uniform capital requirements across countries that diverge in the industrial organization of their banking sectors.